Hedging to make money

Hedging is an investment in order to reduce or nullify a risk taken. It is a strategy to reduce risk.

Let’s take an example I have to receive US$ 100, 3 months from today, the current exchange rate is US$ 1 = Rs. 47. So if the exchange rate remains steady I would receive Rs.4700. But I am not sure what would happen with the exchange rate, so I can sell a 3 month future contract at US$ 1 = Rs. 47. In this way I am assured of Rs. 4700, when I get my US$. In reality what happens, say after 3 months the exchange rate is US$ 1 = Rs. 45. I will receive Rs. 4500 only from the bank, but I will gain Rs. 200 from my future contract.

So is hedging normal, YES. We do it in our day to day life.

By the way, even buying a health insurance is a Hedge. We hedge our risk of an uncertain future event of falling sick and being hospitalized. What we are basically doing is making an investment to reduce or nullify our risk to bankruptcy.

How can we use this to increase our profits? Let us say I feel that there would be an announcement today that will benefit the Telecom Industry and I feel Tata Tele is better than Reliance Communication. But I am not a risk taker, so what can I do?

Let’s say the current price of Tata Tele is Rs. 16 and Reliance Communication is Rs. 216.
So what I will do is buy 63 shares of Tata Tele that will be Rs. 1008 (63 X 16) and short sell 5 shares of Reliance Communication that will be Rs. 1080 (216 X 5)

Now if there is an announcement, since Tata Tele is a better company the price of its share would definitely grow at a faster rate than the price of Reliance Communication. Let us assume the price Tata Tele became Rs.18 and Reliance Communication becomes Rs. 238. What happens? If you sell Tata Tele you will get Rs. 1197 (63 X 19) and you will have to pay for Reliance Communication Rs. 1190 (238 X 5).
Net amount you would have made is
Tata Tele – Profit Rs 189 (1197 – 1008) and Reliance Communication – Loss Rs. 110 (1190 – 1080)
Net Profit Rs. 79 (189 – 110)

But what would happen if the announcement is unfavorable. The prices of both the shares would fall, but Reliance communication would fall at a faster rate than Tata Tele. Let us assume at the end of the day the price of Tata tele became Rs. 14 and Reliance Communication become 173.
Net amount you would have made would be
Tata Tele – Loss Rs. 126 (63 X (16 – 14)) and Reliance Communication – Profit Rs. 215 (5 X (216 – 173))
Net Profit Rs. 89 (215 – 126).

So whatever the news you would make money. But the key would be to know which is a better company.